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Category Archives: Financial Advisors

This is the seventh installment in our series on how individual investors can assess their financial health.

In my experience, I’ve found that many people have no idea how much they’re paying for the privilege of investing. And survey data supports my observations. Ignorance is not bliss. Analysis of investment expenses suggests that many people are probably losing a substantial portion of their potential lifetime investment gains to these expenses—and a considerable portion of them are avoidable.

To understand the true scope of investment expenses, you first need to know the different forms they can take. You’re not alone if you didn’t know about some of these costs.

Brokerage fees – Also known as trading commissions, these are what you pay when you buy or sell securities through a broker. Typically, brokerage costs accrue every time you make a trade, though there are a variety of fee structures.

Mutual fund stated costs – These are the fees that mutual fund management collects for running the fund. They are expressed as a mutual fund’s expense ratio.

Mutual fund trading costs – The costs that funds incur through trading their underlying securities are not included in the expense ratio. They are additional expenses that are passed along to fund investors.

Retirement plan administrative costs – In retirement plans, the costs associated with managing the plan itself are over and above the brokerage fees and mutual fund expenses.

Advisory fees – If you have a financial advisor, he or she may be paid on the basis of sales commissions, a percentage of your assets, or a flat fee.

Cash drag – Mutual funds tend to keep a certain percentage of their assets in cash to support fund share redemptions. These assets are doing nothing, but are still part of the assets subject to the expense ratio of the fund. This is not an explicit fee but it reduces the return of your investment, so I have included it here.

Taxes accrued by the mutual fund – Finally, it’s necessary to account for the tax burden that a fund creates for its investors through the fund’s trading.

The Impact of Fund Expenses

A 2011 Forbes article estimates that the average all-in cost of owning a mutual fund is 3.2% per year in a non-taxable account and 4.2% in a taxable account. This estimate is likely on the high end, but it’s certainly possible that it is accurate. A more recent article estimates that the average all-in cost of investing in an actively managed mutual fund is 2.2% per year, ignoring taxes. But rather than debate these numbers, the crucial question is how much you are spending in your own accounts.

While a 1% or 2% difference in expenses may seem small when compared to variability in fund total returns of 20% or more, the long term impact of those expenses is enormous. Let’s do a little math to show how pernicious expenses can be.

Imagine that you can earn an average of 7% per year in a 60% stock/40% bond portfolio. The long term average rate of inflation in the United States is 2.3%. That means your real return after inflation is 4.7% (7% – 2.3%). If your expenses in a taxable account are as high as the Forbes estimate, you’ll end up with only 0.5% per year in return net of inflation. This implies that the vast majority of returns from stocks and bonds could be lost to the various forms of expenses.

If you find that implausible, consider the fact that the average mutual fund investor has not even kept up with inflation over the past 20 years, a period in which inflation has averaged 2.5% per year, stocks have averaged gains of 8.2% per year. The extremely poor returns that individual investors have achieved over the past twenty years are not just a result of high expenses, but expenses certainly must play a role given the estimates of how much the average investor pays.

A useful rule of thumb is that every extra 1% you pay in expenses equates to 20% less wealth accumulation over a working lifetime. If you can reduce expenses by 2% per year, before considering taxes you are likely to have a 40% higher income in retirement (higher portfolio value equates directly to higher income) or to be able to leave a 40% larger bequest to your family or to your favorite charity.

How to Get a Handle on Expenses

To estimate how much you are paying in expenses, follow these steps.

Obtain the expense ratio of every mutual fund and ETF that you invest in. Multiply the expense ratios by the dollar amount in each fund to calculate your total cost.

Look up the turnover of each fund that you invest in. Multiply the turnover by 1.2% to estimate the incremental expenses of trading. A fund with 100% annual turnover is likely to cost an additional 1.2% of your assets beyond the started expense ratio.

If you use an advisor, make sure you know the annual cost of the advisor’s services as well as any so-called wrap fees of programs that the advisor has you participating in.

Ask your HR manager to provide the all-in cost of your 401k plan.

Add up all of your brokerage expenses for the past twelve months.

Collecting all of this information will take some time, but given the substantial potential impact of expenses on performance, it’s worth the trouble. If, when you add up all of these costs, your total expenses are less than 1% of your assets, you are keeping costs low. If your total expenses are between 1% and 2%, you need to make sure that you are getting something for your money. You may have an advisor who is providing a lot of planning help beyond just designing your portfolio, for example. Or you may be investing with a manager who you believe is worth paying a premium for. If your all-in costs are greater than 3% per year, you are in danger of sacrificing the majority of the potential after- inflation gains from investing.

Conclusions

It is hard to get excited about tracking expenses or cutting costs. The evidence clearly shows, however, that reducing your investment costs could make the difference between a well-funded retirement or college savings account and one that’s insufficient.

Future returns are hard to predict, but the impact of expenses is precisely known. The more you pay, the better your investments need to perform just to keep up with what you could achieve with low cost index funds. This is not an indictment of money managers but rather a reminder that investors need to be critical consumers of investment products and services.

For more analysis of the devastating impact of expenses, MarketWatch has an interesting take.

A question that nags at many people is whether they are on track financially. Even an average financial life can seem remarkably complex. How does anyone know whether he or she is doing the right things? A range of studies on how people manage their money suggests that many, if not the majority, are making choices that look decidedly sub-optimal. Americans don’t save enough money and when they do save and invest, they often make basic mistakes that substantially reduce their returns. More than 60% of self-directed investors have portfolios with inappropriate risk levels. Almost three quarters of Americans have little or no emergency savings. The solution to these problems starts with an assessment of where you are and where you need to be.

The key, as Einstein once said, is to make things as simple as possible but no simpler. In an attempt to provide a checklist that’s in line with this edict, I offer the following questions that each person or family needs to be able to answer.

The first three questions focus on consumption and saving:

Am I saving enough for to meet personal goals such as retirement, college education, and home ownership?

Am I saving enough for contingencies such as a job loss or an emergency?

Am I investing when I should be paying down debt instead, or vice-versa?

The next five questions deal with how you invest the money that you save:

Is my portfolio at the right risk level?

Am I effectively diversified?

Am I aware of how much am I paying in expenses?

Are my financial decisions tax efficient?

Should I hire an investment advisor?

Anyone who can answer all eight of these questions satisfactorily has a strong basis for assessing whether he or she is on track. Odds are there are more than a few questions here that most of us either don’t have the answer to or know that we are not addressing very well.

Part of what makes answering these questions challenging is that the experiences of previous generations are often of limited relevance, especially when it comes to life’s three biggest expenditures: retirement, college, and housing.

For example, older people who have traditional pensions that guarantee a lifetime of income in retirement simply didn’t need to worry about choosing how much they had to save to support themselves during retirement.

The cost of educating children has also changed, increasing much faster than inflation or, more crucially, household income. For many in the older generation, college was simply not a consideration. It has become the norm, however, and borrowing to pay for college is now the second largest form of debt in America, surpassed only by home mortgages. Children and, more often their parents, must grapple with the question of how much they can or should pay for a college education, along with the related question of whether a higher-ranked college is worth the premium cost.

The third of the big three expenses that most families face is housing costs. Following the Second World War, home buyers benefitted from an historic housing boom. Their children, the Baby Boomers, have also seen home prices increase substantially over most of their working careers. Even with the huge decline in the housing crash, many Boomer home owners have done quite well with real estate. Younger generations (X, Y, and Millenials), by contrast, have experienced enormous volatility in housing prices and must also plan for more uncertainty in their earnings. And of course, what you decide you can afford to spend on a home has implications for every other aspect of your financial life.

In addition to facing major expenses without a roadmap provided by previous generations, we also need to plan for the major known expenses of everyday life. It’s critically important to determine how much to keep in liquid emergency savings and how to choose whether to use any additional available funds to pay down debts or to invest. There are general guidelines to answering these questions and we will explore these in a number of future posts.

The second set of questions is easier to answer than the first. These are all questions about how to effectively invest savings to meet future needs. Risk, diversification, expenses, and tax exposure can be benchmarked against professional standards of practice.

What can become troubling, however, is that experts disagree about the best approach to addressing a number of these factors. When in doubt, simplicity and low cost are typically the best choices. Investors could do far worse than investing in a small number of low-cost index funds and choosing the percentages to stocks and bonds based on their age using something like the ‘age in bonds’ rule. There are many ways to try for better returns at a given risk level, and some make far more sense than others. Even Warren Buffett, arguably the most successful investor in the world, endorses a simple low-cost index fund strategy. Upcoming posts will provide a number of straightforward standards for addressing these questions.

Investors who find these questions too burdensome or time consuming to deal with may wish to spend some time on the eighth and final question: whether they should hire an investment advisor to guide them. Investors may ultimately choose to manage their own finances, search out a human advisor, or use an online computer-driven advisory service.

While financial planning can seem complex and intimidating, our series of blog posts on the key issues, as outlined in the eight questions above, will provide a framework by which individuals can effectively take control and manage their financial affairs.

One of the least-understood aspects of investing among individual investors is the total costs associated with building and maintaining a portfolio. In comparison to the huge rises and falls that we see in the market, the expenses associated with mutual funds or brokerage costs may sound small. Over long periods of time, however, the ups and downs of the market tend to average out. The effect of those costs however is persistent and continuous.

There are a range of costs associated with investing in funds beyond the stated expense ratio. In a new article in the Financial Analysts Journal, John Bogle presents a new summary of the average all-in costs associated with investing in stock index funds and in actively-managed stock funds. Mr. Bogle is a long-term and tireless advocate of the idea that actively-managed mutual funds are a mistake for investors, so the content of the article is not surprising. He has written similar pieces in the past. In this article, he provides updated numbers, backed up by a range of academic analysis. His summary of costs is provided in Table 1 of his article:

There are three types of expenses, in addition to the standard expense ratio. First are transaction costs, which are simply a fund’s trading costs. This cost includes brokerage fees incurred by the fund, the impact of the bid-ask spread, and related expenses. Mr. Bogle estimates this cost at 0.5% per year for active funds and at 0% for index funds. He justifies the zero cost for index funds on the basis of the fact that the long-term returns of index funds are essentially identical to the performance of the index net of the index funds’ expense ratio. The second source of additional cost for active funds is cash drag. Many actively managed funds are not fully invested all of the time and carry a portion of their assets in cash. To the extent that this cash does not accrue returns comparable to the equity index, this is a drag on performance. Mr. Bogle estimates this lost return due to cash holdings at 0.15% per year. The final additional cost that Mr. Bogle includes is sales charges / fees. This cost is supposed to capture sales loads and any incremental costs associated with an investment advisor such as advisory fees. Mr. Bogle freely acknowledges that this cost estimate is exceedingly open for debate.

When he adds all of these costs together, Mr. Bogle estimates that the average actively-managed fund costs investors 2.27% per year as compared to the market index, while the index fund costs only 0.06% per year.

The Investment Company Institute (ICI) estimates that the asset-weighted average expense ratio of actively-managed mutual funds is 0.92% per year, for reference. The ICI also reports that the most expensive funds can have much higher expense ratios. They find that the most expensive 10% of equity funds have an average expense ratio of 2.2%.

Mr. Bogle, in his examples, assumes that stocks will return an average of 7% per year. This number is highly uncertain. The trailing 10-year annualized return of the S&P500 is 6.8% per year, but the trailing 15-year annualized return for the S&P500 is 4.2%. A 2.2% total expense is more than 30% of the total return from investing in the stock market if the market returns 7%. Because of compounding, the long-term impact of these costs increases over time.

The average costs from Mr. Bogle’s article are not unreasonable. There are probably many investors paying this much or more. On the other hand, there are plenty of investors in active funds paying considerably less.

Where does all of this leave investors? First and foremost, it should be clear that costs matter a great deal. There will always be expenses associated with investing, but they vary widely. Over a lifetime, managing the expenses of investing can have a dramatic impact on your ability to build substantial savings. Whether or not you believe that actively-managed funds are worth their cost, every investor should know their own asset-weighted expense ratio.

As the market rally persists, many investors will no doubt be kicking themselves and wishing that they had bought in earlier. Some will convince themselves that they better get on board or risk missing out on this bull market. There are many good reasons to invest money, but choosing to get in because of the potential gains that you could have made is not one of them. In the same way that people capitulate and sell out near market bottoms, there is also a big behavioral driver that seems to make people capitulate and join the herd towards the end of big bull markets. I am not saying that we are poised for decline (I am not a good market timer), but simply noting that buy or sell decisions made on the basis of what you wished you had done last month or last year is often truly dangerous. Continue reading →

I have known Phil DeMuth for a number of years and I admire his common sense and views on many topics. Phil authored the recently-published book The Affluent Investor that fills a need in the crowded shelves of investment books. As a financial advisor to high-net-worth families, Phil brings valuable perspective to investors who have built substantial portfolios and seek to protect and grow their wealth effectively. Continue reading →

Editor’s Note: John Graves has been an independent financial advisor for 26 years. He is one of the two owners of The Renaissance Group, a Registered Investment Advisor based in Ventura, CA. John’s book, The 7% Solution: You Can Afford a Comfortable Retirement, was published in 2012. When I read this book, I was impressed with John’s approach and thinking and I recommend it as a good read. I contacted John and asked if he would consider contributing to this blog. After we bounced around some possible topics, he sent me the following piece that describes his process for designing income plans for retirees. Continue reading →

There is currently $5 Trillion invested in Individual Retirement Accounts (IRAs), $4.7 Trillion invested in self-directed retirement plans provided by employers (401(k), 457, and 403(b) plans), and $2.3 Trillion invested in traditional pension plans offered by private companies. These numbers are stunning for a number of reasons. First, self-directed retirement plans (IRAs, 401(k)’s, etc.) dramatically dwarf the amounts invested in traditional pensions. This is part of a long-term trend, as employers move away from traditional pensions, but the magnitude of the shift is striking. With the assets in IRA’s surpassing the $5 Trillion mark earlier this year, the amount of money in individual accounts is moving ahead of employer-sponsored plans. What’s more, it is anticipated that IRA’s will continue to grow relative to employer-sponsored plans as people retire and roll their savings from their ex-employer’s plan into an IRA. This matters because investors in IRA’s have even less help in creating and maintaining their portfolios than investors in employer-sponsored plans. Continue reading →

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